Journal of APPLIED CORPORATE FINANCE in THIS ISSUE

VOLUME 31 NUMBER 1 WINTER 2019 Journal of APPLIED CORPORATE FINANCE IN THIS ISSUE: 8 The Rise of Agency Capitalism and the Role of Shareholder Activists Agency in Making it Work Ronald J. Gilson, Columbia and Stanford Law Schools, and Capitalism Jeffrey N. Gordon, Columbia Law School 23 The Effect of Shareholder Approval of Equity Issuances Around the World Clifford G. Holderness, Boston College 42 Does Mandatory Shareholder Voting Prevent Bad Acquisitions? The Case of the United Kingdom Marco Becht, Université libre de Bruxelles, CEPR, and ECGI; Andrea Polo, Luiss University, Universitat Pompeu Fabra, EIEF, Barcelona GSE, CEPR and ECGI; and Stefano Rossi, Bocconi University, CEPR, and ECGI 62 The Early Returns to International Hedge Fund Activism: 2000-2010 Marco Becht, Université libre de Bruxelles, CEPR, and ECG; Julian Franks, London Business School, CEPR, and ECGI; Jeremy Grant, Berenberg Bank; and Hannes Wagner, Bocconi University, ECGI, and IGIER 81 How Has Takeover Competition Changed Over Time? Tingting Liu, Iowa State College, and Harold Mulherin, Georgia State University 95 Do Large Blockholders Reduce Risk? David Newton and Imants Paeglis, Concordia University 113 Estimating the Equity Risk Premium and Expected Equity Rates of Return: The Case of Canada Laurence Booth, University of Toronto 126 Save the Buyback, Save Jobs Greg Milano and Michael Chew, Fortuna Advisors Save the Buyback, Save Jobs by Greg Milano and Michael Chew, Fortuna Advisors n a recent New York Times editorial, Senators Chuck Schumer and Bernie Sand- I ers described stock buybacks—and dividends, too—as “corporate self-indulgence” and “an enormous problem for workers and for the long-term strength of the economy.” It’s true, of course, that the growth of jobs and median wages in recent decades has been disap- pointing, but the senators identify the wrong culprit. And in so doing, they perpetuate a misconception about the role of dividends and buybacks. Besides failing to note how such payouts increase capital productivity, the senators miss their critical economic function of recycling “excess capital” from large, mature companies with fewer investment or employ- ment opportunities to the next generation of Apples and Amazons. According to Schumer and Sanders, U.S. companies in thrall discipline and commitment to providing competitive returns to shareholder value maximization are buying back their on capital. Such distributions return cash to investors, who shares to boost earnings per share—and presumably their then reinvest it in growth companies that create jobs in more stock prices—while cutting back on long-term investment. attractive industries. To curb this behavior, the senators propose regulations that Given that dividends and buybacks both allow compa- would require companies buying back shares to make simul- nies to return excess capital to their shareholders, are there taneous and comparable investments in projects that create reasons for companies to prefer buybacks? Buybacks are more jobs. And to make companies think twice about increasing tax-efficient because they allow investors to self-select on the dividends, they propose putting yet another tax on them— basis of their own tax positions—and then pay tax at the perhaps forgetting that the U.S., almost alone among nations, lower capital gains rates, and only on their gains above the already taxes dividends twice, first as corporate income and purchase price, instead of on the full distribution. For compa- then on investors’ returns. nies, buybacks preserve flexibility by avoiding commitments What the senators also fail to recognize is that, for compa- to higher, and possibly unsustainable, dividend payouts, which nies that are truly intent on enriching their shareholders, the tend to be viewed as “fixed costs.” focus is much less on increasing next quarter’s EPS than on One other common motive for buybacks is to recoup earning competitive returns on capital and investing in their the value of “undervalued” shares—but this has proven to long-run “earnings power.” The way to do that, as business be a double-edged sword. As our own research shows, many schools and the likes of Warren Buffett have preached for companies have ended up overpaying by buying at the wrong decades, is to follow the Net Present Value rule: take all invest- time. To track buyback performance, we have developed a ments expected to earn at least their cost of capital, and walk measure called “Buyback ROI,” which can be compared to away from the rest. The role of buybacks and dividends in returns on capital spending, acquisitions, and other invest- this long-run value creation process, as suggested, is to pay ments. It is calculated as an internal rate of return (IRR) that out “excess capital” left over from earnings that cannot be views the amount spent on buybacks as the “investment,” and reinvested in profitable growth opportunities. By returning the dividends saved on the repurchased shares plus apprecia- capital to shareholders, companies convey their spending tion of (or loss on) the retired shares as the return. In a study 126 Journal of Applied Corporate Finance • Volume 31 Number 1 Winter 2019 we published in 2018, three out of every four companies in But how, then, should companies address the senators’ our sample of S&P 500 companies (defined by minimum problem—how can they avoid underinvestment and encour- buyback thresholds) mistimed their repurchases over the age their managers to take on all projects expected to produce prior five years to such an extent that their Buyback ROI was value-adding growth? below their total shareholder return. Our finding reflects the In my forthcoming book, A Cure for Corporate Short- well-known tendency of companies to buy back their shares Termism, I argue that companies should reexamine their closer to the peaks of business cycles than the troughs—with performance-measurement, decision-making, and reward the result that such companies end up repurchasing far fewer systems to make sure they are not discouraging managers shares than would be possible with better timing, and so from taking positive-NPV projects. As one simple example, shortchange their remaining shareholders. But this should not bonuses tied to year-to-year increases in returns on capital come as a surprise, since corporate cash generation tends to be may well be encouraging the managers of a company’s most at its highest, and investment opportunities most expensive, profitable business segments to limit their growth invest- when nearing the tops of cycles. ments. If your business is already earning 40% on capital, What can companies do to avoid falling into this trap? why take on a project earning 30% and drag down the How can managements commit to paying out their excess average? Companies can correct this problem by realigning capital, while avoiding the temptation to buy back shares at their business management processes around a measure of overly high prices? economic profit—one that charges business units for their use of capital, but without penalizing new investments that could reduce their average return. Finally, what should regulators do to address this under- “ investment problem? The short answer is nothing. Buybacks In our 2018 study, three out of every four companies are not a cause, but rather a symptom, of the problem. In ... mistimed their repurchases over the prior five years response to technological change and obsolescence, capital spending on manufacturing and traditional plant and to such an extent that their Buyback ROI was below equipment has been falling for decades in all of the world’s their total shareholder return. developed economies. But U.S. corporate investment in R&D has continued to be strong, reflecting the global shift from ” tangible to intangible assets. And buybacks and dividends, far from contributing to an Companies should use dividends as their primary way of underinvestment problem, are playing an important role in paying out their “normal” levels of free cash flow—that is, bringing about this shift. What the senators fail to recognize is the difference between their recurring cash flows and their that the capital paid out by U.S. companies to their sharehold- normal reinvestment in the business. There is no timing or ers does not disappear from the economy. As Harvard law and “wealth transfer” risk with dividends since all shareholders are economics scholar Mark Roe pointed out in a recent study, treated the same. Unexpectedly high cash flows can be used in each year during the past decade, some $250 billion of to fund stock buybacks, but only if management is convinced net new capital has flowed into smaller (non-S&P 500) U.S. that the company is overcapitalized and not overvalued. companies. And this figure would be much larger if it included And to guide the timing of their stock repurchases, compa- the venture capital, angel investing, and private equity that nies should consider establishing objective signals based on is effectively funded in part by the distributions of public performance and valuation metrics that indicate a reason- companies. In other words, the buybacks and dividends of ably high probability of an acceptable Buyback ROI. Given more mature companies are being recycled by investors into the sheer size of many buyback programs, the gains for the those companies that have been responsible for most of the long-term shareholders of companies achieving even minor job creation in recent years. Why would we want to stop this improvements in buyback timing could be very large. And in virtuous cycle? cases where the risk of overvaluation is substantial, manage- The main effect of the senators’ proposals would be to ment should either be patient or consider the use of special trap more capital inside companies that don’t have productive dividends to avoid both the wealth transfers associated with uses for it.

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